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Thursday 27 Dec, 2012
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Explainer: What is the ‘fiscal cliff’ and why does it matter?

The US is facing a potentially devastating financial crisis in less than a week but what is it all about, what impact will it have on Ireland and what’s got to happen if it is to be avoided? TheJournal.ie explains…

You’ve probably been hearing a lot about the impending ‘fiscal cliff’ in recent weeks but just what exactly is it? What could be so important that Obama has to cut short his Christmas family and golf time in Honolulu?

Briefly, the fiscal cliff is a series of tax rises and spending cuts which are automatically due to come into effect on 1 January which is as soon as next week.

Such is the extreme nature of the fiscal measures they are predicted to almost certainly plunge the US into recession next year which would be devastating to the country, Obama’s second term and the global economy.

A pretty big deal then. How did it come to this?

You may remember that in August 2011, President Obama and Congress struck a deal to raise the United States’ debt ceiling - the legal limit placed on the amount of debt the country can run up – having been on the brink of reaching the $14.294 trillion ceiling that summer.

In doing this both houses of Congress – the Senate and the House of Representatives – passed the Budget Control Act, a law which committed the US to cutting overall government spending in a bid to reduce the country’s deficit – the gap between money spent by the government and revenue raised.

In order to cap government spending over ten years and find budget savings of $1.2 trillion over that same period a bipartisan ‘supercommittee’ was established to identify where long-term and sustainable adjustments could be made in order to avoid the kind of brinkmanship experienced during the debt ceiling crisis.

But this committee failed to reach an agreement meaning that a so-called sequester of automatic, across-the-board spending cuts and tax rises would come into effect on 1 January 2013 – these measures are known as the ‘fiscal cliff’.

Why? Because they are measures considered so severe that they are predicted to plunge the US into recession next year – hence the country would go ‘off the cliff’, fiscally speaking.

What kind of measures are they that they would lead to the US going ‘off the cliff’?

Some of the measures include the expiration of federal tax cuts and breaks that were enacted under the presidency of George W Bush in 2001 as well as a payroll tax holiday that Obama enacted in his first term. These tax changes would hit an estimated 88 per cent of all US taxpayers, making almost all of them worse off.

For the ordinary, middle-income American – which is 60 per cent of the US population – the Tax Policy Center says they would face an average annual tax rise of about $2,000.

There would also be federal spending cuts particularly in areas like defence but most other federal agencies would also be affected and benefits for the unemployed would automatically expire for two million Americans who are currently out of work.

Overall the deficit reduction measures would be made up of two-thirds tax increases and one-third spending cuts and would total $607 billion.

This pie chart from a helpful New York Times powerpoint gives you an indication of what sort of cuts and tax hikes will be coming into force without a deal to avoid the fiscal cliff:

For the wider US economy the Congressional Budget Office (CBO) says that the real gross domestic product in the US would decline by 0.5 per cent in 2013 with a big drop in the first part of the year. Some analysts predict it the economy could decline by as much as four per cent.

Unemployment, which has stayed below 8 per cent in recent months, would shoot up to over 9 per cent by the end of next year, the CBO says.

How would this impact on Ireland and the world?

Globally, the impact cannot be underestimated. The old saying ‘when America sneezes, the rest of the world catches a cold’ would ring true with the International Monetary Fund among those predicting a knock-on effect on the world economy if the US economy declines.

The eurozone economy is already predicted to contract by 0.3 per cent next year and the US going over the fiscal cliff would have an even greater impact on this.

For Ireland, exports to the US – which account for almost a quarter of all Irish exports – would suffer and inward investment from major US-based multinationals would also be impacted.

Since the not-so-super ‘supercommittee’ failed Congress, where the Republicans control the House of Representatives, has been wrangling with the White House in an attempt to reach an agreement.

Unless some sort of a deal can be worked out before the turn of the year then the US will go over the fiscal cliff on 1 January, that’s next Tuesday.

How did it get to the point where the US is facing this sort of crisis?

The simple answer is that aside from the all the economic turmoil that has afflicted the US and global economy in the last five years, tax rates in the States have gone down while government borrowing and spending have gone up.

Tax cuts, like those introduced by Bush, are good an era when the economy is booming and there is more tax revenue coming in but when it starts to decline it can create problems especially when rising unemployment places a greater burden on government welfare programmes.

The share of income most families pay taxes on has been falling for the past 30 years, according to the Wall Street Journal. In 1981 the middle of the middle class in the US paid 19 per cent taxes. In 2007 they gave 14.3 per cent of their income to the tax man.

This table from BBC News shows how tax cuts during the George W Bush administration came down from his predecessor Bill Clinton’s time in office and led to the current situation:

While all of this is happening government spending has been increasing. At present one out of every four dollars spent by the US government goes towards healthcare compared to 1960 when less than 10 per cent of overall federal spending went towards health.

In the area of defence one in every five dollars the US federal government spent last year was in this area. Defence spending has rocketed in recent years because of the wars in Afghanistan and Iraq.

So why not just let the Bush tax cuts expire?

Well this would hit everyone including struggling middle-income families. President Obama does not want to let all of the Bush-era tax cuts expire but does for those on higher incomes. He argues that those who earn more, specifically the wealthiest two per cent in America, should pay more.

This is anathema to the Republican Party which takes a dim view of taxes in general. Over 90 per cent of the party’s members who serve in the US congress have signed the so-called ‘Taxpayer Protection Pledge’ – the brainchild of Americans for Tax Reform president Grover Norquist – which commits them to opposing increases in marginal income tax rates.

There is a recognition from both sides of the need for concessions.

Obama has pledged to change the way Social Security (social welfare) cost-of-living adjustments are made for some recipients and cut spending on government healthcare programmes.

But when the Speaker of the Republican-controlled House of Representatives and defacto leader of the opposition, John Boehner, offered to allow the Bush tax cuts to expire for those earning more than $1 million this was rejected by his own party.

The reason it’s called the fiscal cliff is because going off it is supposed to be so unpalatable that both sides – Democrats and Republicans – will do all they can to avoid it.

For the Republicans they do not want the Bush-era tax cuts to expire or defence spending to be cut so deeply. Here’s Boehner summing-up his side’s view during what was probably the shortest press conference ever on 19 December:

For Democrats they want to avoid cuts to other federal government programmes as well as avoid a temporary payroll tax that Obama introduced expiring on 1 January. here is Obama summing-up his side’s view, also on 19 December:

So where do we go from here?

With days to go before the deadline there is no agreement and no sign of one. While Obama returns to Washington, the rest of the country’s lawmakers show no immediate signs of coming returning from their own Christmas breaks to forge a deal.

To complicate matters the US Treasury Secretary – the US’ finance minister – Tim Geithner has said that the statutory debt limit – that debt ceiling we mentioned earlier – will be reached by 31 December or Monday.

This means that the US won’t be able to borrow any more money to service it’s debt and it will default. Fortunately some ”extraordinary measures” taken by the Treasury will postpone the date it has to pay some of its bills.

This is effectively moving money around and kicking the can down the road to February or early March when the debt ceiling of $16.4 trillion will be hit again and the US really will default unless more permanent action is taken.

All of which makes it incumbent on lawmakers to reach some sort of deal.

By Monday?

Well in an ideal world yes but if a deal is not reached before then there is an expectation that it would not be an immediate catastrophe. After all, US citizens like the rest of us don’t have to pay all of their taxes for the year right at the start of it.

But going off the cliff would be a demonstration to the world that the US cannot handle its finances, stock market confidence would plummet, its already cut credit rating could be cut further and it would be a huge blow to Obama with his second inauguration on 20 January.

So then, what’s going to happen?

Well we can’t tell you that because we just don’t know but there are now three likely scenarios. In order of likelihood here they are:

A stalemate where the Bush tax cuts expire and the spending cuts are implemented.

A partial renewal of the Bush tax cuts involving some but not all of them being extended

A short-term fix involving the partial extension of Bush tax cuts, a delay on spending cuts, and some deficit reduction measures.

But in truth it’s difficult to predict just what might happen between now and next week. Which means that the next few days in the US will be dominated by rhetoric and brinkmanship with the rest of the world watching on, nervously.

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